French plan to save face over the franc; ECONOMIC VIEW

Click to follow
Expect a French franc devaluation. Ever since the presidential election, sporting Britons in Paris have been betting on the timing of the next devaluation, but the clearest signal that the ground is being prepared came from the Halifax Group of Seven summit. The French president, Jacques Chirac, was generally regarded as the star of the show - self- confident, ebullient, bossy - but he will be most remembered for calling currency speculation the Aids of the global economy.

Leave aside whether the simile is apt. What matters is not whether the president is right, but why he is saying this.

Think back to the late George Brown. He popularised the phrase the "gnomes of Zurich" to describe the people who speculated, successfully as it turned out, against sterling before the 1967 devaluation. French devaluation will be seen as a humiliation, and someone outside France will have to be blamed, just as the effective break-up of the ERM was portrayed as an Anglo-Saxon plot. The "all the fault of the Anglo-Saxons" line could be trotted out again, but it would be unoriginal. Since the French business community would welcome a devaluation, it would not be wildly credible, either. Far better to blame the anonymous foreign exchange speculators; better still to blame them before they start the run, so the politicians can say they told us so.

That is the politics, so what about the economics? The case for a devaluation is not that France has had a poor inflation record and needs to adjust its currency to allow for that, for at the retail price level, the performance has been very good. Nor is it that she is in account difficulties; she is in decent current account surplus and is projected to remain so. The problem is that given France's very high unemployment and the new government's commitment to cut that, economic growth has to be lifted. Unemployment is more than 12 per cent and is forecast to fall to about 11.5 per cent by the end of next year.

There is no room for manoeuvre on fiscal policy. A mini-budget is now being prepared which will introduce additional spending directed towards reducing the jobless total - a subsidy for companies which recruit the long-term unemployed and young people, and a cut in social security payments by small firms. But these measures will have to be paid for by additional taxation, including a rise in VAT, the general rate of which is expected to be put up from 18.6 per cent to 20 per cent. The new prime minister, Alain Juppe, has said that all new spending measures will be more than covered by additional taxation: "Everything," he said last week, "will be financed down to the last detail."

In fact, the situation is worse, for it looks as though tax revenues have been running below projections in the first part of this year. If it is to keep or improve on the debt-reduction programme of the previous government, the new French leadership will have to tighten fiscal policy further, despite the high unemployment. Their hope is that by doing so, they will be able to boost market confidence and so cut interest rates.

That is the key issue. France needs cheaper money. But she cannot cut rates below German rates. Indeed, short-term rates have had to be increased this year because of pressure on the franc.

The bind in which French policy finds itself is set out in the charts. Monetary policy has been eased greatly, as shown by the rise in money supply, but while France has until recently shared in the general interest rates fall which has taken place everywhere, this year has seen a significant reversal of that fall. It is possible that an apparently tough fiscal package will help boost confidence and enable that last little upward kick in money market rates to be reversed. It is a nice idea and it may work. But as the second graph shows, producer prices have been shooting upwards this year, which will limit potential for interest rate cuts. Indeed, this rise in producer prices threatens the whole French strategy of securing low inflation for such a long period that the markets will finally deliver the low interest rates which that good inflation record ought to secure.

In any case, the deteriorating outlook for global growth in recent weeks undermines the growth forecasts on which even the quite modest cuts in unemployment are based.

There are two ways of cutting through the jungle. Plan A would be to engineer a Europe-wide cut in interest rates. This would have to be led by Germany as the mark is the dominant European currency. This is not to be dismissed as a possibility and it has clear political attractions. The trouble is that it requires the connivance of the Bundesbank, which jealously guards both its independence and, almost more important, its reputation for independence from political pressure. If there are genuine domestic reasons for an easing of German policy, this might work, but suppose the Germans do not cut rates ...

Plan B would be to follow the post-ERM British policy of cutting interest rates, allowing some currency depreciation and relying on low demand holding down domestic inflation. This would bring faster growth, the depreciation could be accommodated within the ERM bands, and the speculators could be blamed.

Which plan will prevail? My guess is that plan A remains the preferred option, but plan B is the acceptable fall-back. But it is perfectly possible France will stage a pre-emptive strike, cut interest rates unilaterally and allow a significant devaluation. Timing? That may depend on the markets, but remember when people take holidays in France. For weak currencies, August is a wicked month.